The ETF Revolution

Jul 16, 2000

Article By: Scott Burns

Is it twilight for the mutual fund industry--- or just late in the Happy Hour?

That question came to mind as I contemplated the most recent developments in a product that could cap the expansion of the mutual fund industry as we know it and accelerate the change from transaction based financial services to asset based financial services. It could also offer do-it-yourself investors cost savings that make even Vanguard look a bit pricey.

The product? Exchange Traded Funds, the unit trust-like investments that hold shares in an unmanaged list of stocks and trade through the day just like shares of Intel or Home Depot. With operating expenses as low as 0.09 percent a year and rapidly vaporizing brokerage commission expenses, ETFs could make long term investing virtually free. They could also introduce a new era of asset class trading and speculation since the shares can be margined and sold short.

The American Stock Exchange introduced the first EFT in 1993. Called SPDRs for Standard and Poor's Depository Receipts, the shares represented all the stocks in the S&P 500 index. Unlike closed end mutual funds, EFT shares could be created or redeemed in large blocks called Creation Units that were handled by specialist firms. The specialist firms are charged with the task of maintaining an orderly market for the units, keeping their market prices very close to the underlying value of the trust shares.

Each Creation Unit holds actual shares of the stocks in the index. DIAMONDS, units representing the 30 stocks in the Dow Jones Industrial Average, and a unit that tracked the NASDAQ 100 Index soon joined SPDRs. WEBS (World Equity Benchmark Shares), units representing the stocks in the Morgan Stanley stock indices for individual countries and sponsored by Barclays Global Investors were introduced in 1996. The SPDRs have also been expanded to represent nine different sectors of the S&P 500 Index list.

Merrill Lynch joined the fray in 1998 with HOLDRS (Holding Company Depository Receipts) and added two in June (Regional Banks and Utilities). They now have a dozen HOLDRS specialized in telecommunication, pharmaceuticals, biotechnology, semiconductors, and five different segments of the Internet. Significantly, the Merrill units have annual expenses of less than 0.10 percent--- nearly half the cost of Vanguards' Index 500 fund which, in turn, costs less than one sixth of the average managed equity fund.

Indeed, Vanguard, seeing a threat and an opportunity, filed an amendment to its Securities and Exchange commission registration statement for its nine U.S. equity index funds in May, seeking to create a new class of ETFs for five of the funds--- Vanguard 500 Index, Vanguard Total Stock Market Index, Vanguard Growth Index, Vanguard Value Index, and Vanguard Small-Cap Index, calling them VIPERS for Vanguard Index Participation Equity Receipts.

Less than a week later, Barclays Global Investors announced that it would be expanding its ETF offerings to over 50 by mid July. Called "iShares", the Barclay ETFs will range from representations of the Russell 1000 and S&P 500 Indices to sectors based on Dow Jones indices.

Put it all together we've got a brand new investor toolbox.

What's the payoff for you and me? Collectively, the cost savings could be in the billions. A Price Waterhouse Coopers study of indexing, for instance, estimates that U.S. institutional investors currently save $14 to $18 billion each year by indexing. The mere existence and success of ETFs will serve to put pressure on mutual fund companies to lower their management fees.

And for good reason. The same study also shows that actively managed retail large cap stock funds trailed investing in the S&P 500 index by 2.00 percent a year after adjusting for costs and survivorship bias.

(Survivorship bias, seldom discussed by mutual fund marketers, is the upward bias fund returns are given by having the poorest performing funds quietly disappear.)

This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

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